Chidambaram’s Fiscal Challenge

India’s finance ministry expects gross domestic product expansion of about 5.5% in the year ending March 31.

Finance Minister P. Chidambaram faces a daunting challenge as he prepares to present India’s federal budget on Feb. 28: how to shore up the nation’s public finances at a time of sluggish economic growth and pre-election populism.

Mr. Chidambaram needs to show investors and credit rating agencies the government is serious about cutting down India’s budget deficit from the expected level of 5.3% of GDP this fiscal year to 4.8% by March 31, 2014 and 3% by 2017.

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Lackluster growth will make that task more difficult, putting pressure on the country’s tax receipts. India’s finance ministry expects gross domestic product expansion of about 5.5% in the year ending March 31 – the slowest pace in a decade. Economists expect slow growth to continue next year.

The government doesn’t have great options to boost revenue. It can’t enact significant increases in tax rates without discouraging business investment that is sorely needed, economists say. The improvements on the revenue side of the ledger in the next fiscal year will have to come largely from bringing more people under the tax net, they say. Only 3% of India’s population of 1.2 billion pays income tax, according to data from tax authorities.

Rajeev Malik, an economist at CLSA, says direct and indirect taxes are unlikely to be raised, but there is a possibility the government could introduce a temporary levy such as a surcharge on the very rich or an inheritance tax.

The government also could increase revenue by auctioning off telecom bandwidth and selling stakes in state-run companies. N.R. Bhanumurthy, an economist with the National Institute of Public Finance and Policy, a think tank, says improved market conditions could encourage the government to target as much as 400 billion rupees ($7.4 billion) in stake-sale proceeds in the next fiscal year, up from the 300 billion rupees it hopes to raise this year.

But even if the government meets its targets for telecom auctions and stake sales, that would account for just 12% of India’s fiscal deficit.

The government is expected to continue pushing its proposals to overhaul the archaic income tax code and replace numerous central and state taxes with a single “goods and services” tax. Implementation of these measures is unlikely anytime soon, but Mr. Chidambaram could spell out a roadmap in the budget to show that the government is serious, economists say.

Meanwhile, populist pressures are running high. This is the government’s last budget before next year’s general elections, so containing spending on subsidies and welfare programs won’t be easy. The ruling Congress party’s advocacy for development programs for the poor has been a major reason for its electoral success in the past two national contests, especially in rural areas.

Mr. Chidambaram has managed to slash spending somewhat and has partially deregulated diesel fuel prices. In a research note ICICI Bank said it expects the government to cap the subsidy bill at 1.8% of GDP for the next fiscal year, compared to an estimated 2.4% this year – helped by the fuel price increase and planned cuts in spending on fertilizer subsidies.

But those efforts could be offset by additional expenses such as a major expansion in food subsidies. Food security legislation the government is considering would provide food at extremely low prices to about 70% of the country’s population. Food minister K.V. Thomas has said it would cost the exchequer about 200 billion rupees ($3.7 billion) in the next fiscal year, increasing by 20% the government’s food subsidy spending.

Robert Prior-Wandesforde, an economist at Credit Suisse, says the government could face severe consequences if it doesn’t meet its targets for slashing the fiscal deficit. That could lead to a downgrade in India’s sovereign credit rating to junk status, which would be “a damning verdict on the government’s management of the economy,” he said. “The credibility of the government would also be hit hard and its chances of getting back into power would be damaged.”

Mr. Chidambaram will be hamstrung as long as growth is anemic, experts say. He has taken several steps since September in an effort revive the economy and boost investment flows, including allowing foreign investors greater access to sectors including Indian television broadcasting, retail and civil aviation.

Now, economists say, it is vital that the government find ways to incentivize investments in India’s infrastructure. Some economists estimate that deficient electricity networks, roads, ports, airports and other facilities shave two percentage points off the country’s GDP growth rate.

The government has called for $1 trillion in public and private investment in infrastructure in the five years ending in 2017. Infrastructure projects already enjoy a tax holiday. But the government levies something known as the minimum alternative tax, which partly dilutes the benefits of the tax break. Industry trade groups are demanding the removal of this alternative tax.

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